The High Cost of Hidden Pension Promises

For mayors across the country a single budget item threatens their cities' capacity to maintain parks, keep the streets safe, pick up the trash and...

For mayors across the country a single budget item threatens their cities' capacity to maintain parks, keep the streets safe, pick up the trash and educate children--all the important things a city government does. That single cost is pension and health care payments to retired city employees.

The notion of pension obligations is abstract, and hardly high on the list of citizen concerns. But within a decade, mountains of unfunded liabilities will seriously erode the quality of city life and force taxes so high that those with the ability to pay will abandon cities, putting municipalities into a death spiral of high costs and poor services. Very soon, the abstract notion of pension costs will have a very real and very damaging impact on the lives of citizens.

A series of GAO reports dating back to 2008 underscores the challenge faced by state and local governments, estimating their total unfunded OPEB (Other Post-Employment Benefit) liabilities at nearly $1.6 trillion dollars. And the problem is worsening. While more than half the states had fully funded pension systems in 2000, only four could claim full funding by 2008. And despite the fact that the fiscal condition of their funds have worsened significantly in the economic crisis, many local and state governments still behave as if strong market returns will enable them to fund expensive labor contracts.

These public entities aggravate the problem with only a third of them currently making the actuarially required contributions. This is like skipping a credit card payment when you carry a big outstanding balance--it puts more money in your pocket in the short term, but it means that taxpayers will end up paying even more down the road. At the very least, this funding shortfall erodes government's financial and political strength, as officials oscillate between bleeding taxpayers and ignoring other responsibilities.

Governments face the possibility of following California down the road to epic failure. Since 1999, California's public pension outlays have swelled by 2,000 percent, but state revenues have increased only 24 percent. More important perhaps, the state has failed to consistently pay its actuarially required contribution, moving California from a $9 billion pension surplus in 2000 to a $53 billion unfunded liability in 2007. Efforts over the past year to make pension payments have diverted more than $2.5 billion away from productive use--and in a state without a dime to spare. This massive unfunded liability is affecting the state's bond ratings, which now are now abysmally low compared to other high population states. The California fiscal picture is disastrous: outlays grossly exceed expected revenues; required contributions are chronically unpaid; resources are painfully diverted from needed services; and the state's credit rating of A- is the worst among the 50 states, and on par with nations such as Estonia and Libya.

State and local governments don't have to follow California down the road to ruin. To figure a way out, though, we have to understand the way in. How do state and local governments end up with exploding outlays and an inability--an institutionalized unwillingness--to make their regular required contributions?

When columns such as this one discuss the problem, it often comes across as an economic problem. At its heart, however, this is a political problem. The pension problems facing state and local government aren't the result of unavoidable economic circumstances; rather, they are the consequence of political choices. General taxpayers need a way to once again assume control of their governments' budgets.

Moving this mountain could start with a few well placed nudges--smart common sense changes. For example, restoring the rights of taxpayers could begin with efforts to crack down on the abuses which pervade pension systems. These abuses range from outright illegal fraud to more genteel gaming of the system. The FBI has brought indictments for disability fraud on the Boston Fire Department, but more common are the within-the-rules manipulations that artificially boost pensions. These tricks include drawing substantial early retirement pensions while moving on to a second career, pension-spiking by "selling back" unused vacation time shortly before retirement, or "buying back" time served in volunteer municipal positions to spike longevity multipliers.

At bottom, however, the problem is essentially one of moral hazard. Elected officials have little incentive to resolve a pension problem generally not even of their making. It makes political sense for state and local officials to boost promised benefits for today's workforce in order to secure labor peace with the hope that these promises will be easier to pay for in the future. The result is that much of their OPEB liability may be unfunded. The fact that policymakers can easily make decisions for which they do not have to bear the consequences encourages fiscally dangerous and morally objectionable behavior.

Structural disincentives also affect these decisions. The use of cash accounting means lawmakers and union officials will not bear the consequences of the benefit increases until a later time. And union leaders often negotiate current contracts where approval involves retirees' votes thus presenting a very difficult dynamic. This is essentially what happened in California, where the California Public Employees' Retirement System (CalPERS) sharply increased benefits for state retirees in 1999 - with the board president claiming a "historic opportunity" that he promised would cause no additional taxpayer burden. Pensions went through the roof--and the bill is just now coming due.

A better approach involves more transparent accounting standards that allow rating agencies and diligent bloggers to inform the public of true costs. Public leaders can more effectively manage the tradeoffs with a more informed public balancing out special interests. A process involving inscrutable labor agreements, with opaque costs, approved by select legislative committees, does not lend itself well to democratic control. Specific legislative authority should be required when the retirement pensions create debt (i.e. future obligations that exceed available income) or when any arcane provisions increase existing liabilities.

Houston shows us both the bad and the good of public pension approaches. During the 1990s, the city's three pension systems were adequately funded on an actuarially sound, consistent, and financially supportable basis. Benefit changes caused the city's actuarially determined contributions to increase from 10 percent to over 50 percent of payroll for HMEPS (municipal employee pensions); from 17 percent to around 30 percent of payroll for HPOPS (police pensions); and from 15 percent to around 30 percent of payroll for HFRRF (firemen's pensions). But Houston shows us a way out--an example of smart public action that allows a state or local government to avoid the California road.

Beginning in 2004 the city administration under Mayor Bill White began reforming pension practices to make benefits more secure, bringing pension liabilities and funding obligations to a manageable level that were supportable at a sustainable long-term level by the city and its taxpayers. First, the city took important short-term steps to strengthen the system, including a scheduled increase of city contributions through 2007; a reduction in the rates of future employee benefit accruals; and an increase in the employees' contribution rate from 4 percent of pay to 5 percent of pay. The financial effect of these interim, short-term steps was to reduce the actuarially determined City contribution rate from over 50 percent of payroll to about 24 percent of payroll--indicating a significant move in the right direction.

But since 24 percent was still substantially greater than the 15 percent of payroll approved by the City Council and the Texas State Legislature in 2001, the Administration decided their job wasn't done. The city proposed additional reforms in 2007 that would further reduce the pension liabilities and provide a more permanent, long-term solution to bringing future City contributions to HMEPS (which provides most city pensions) closer to a desirable and financially supportable level. These additional reforms were adopted without reducing any current employee's accrued or projected benefits. They included implementing a new benefit structure applicable to employees hired in 2008 and after; and establishing a scheduled increase of city contributions through 2011. As a result, Houston's scheduled contributions to HMEPS for each fiscal year through 2011 are projected to be in the 15- 16 percent of payroll range each year.

As Houston proves, a return to fiscal soundness can be accomplished. Generally, such a return to rationality can be achieved by attending to three areas: How retirement benefits are set; how they are scored and whether they are fully funded on an accrual basis. Houston and states like Florida's FRS Pension Plan provide something of a roadmap to fiscal soundness. But that's only part of the solution. Even the best map becomes worthless without a vehicle to get there.

Where do we find--or how do we create--the political will needed to change our roadmap into an operational tool? Ultimately, heading off the tidal wave of pension problems--a wave that will otherwise threaten the utter devastation of city and state finances requires political will. That will can be cranked up with more general taxpayer public pressure--but it means making clear to the public how the abstract notion of pension obligations will impact their lives without real, meaningful reform.